Stock Market Crash

A swift simultaneous price decline in a significant number of securities in a stock market leads to a stock market crash. Such crash generally causes a huge loss of paper wealth. There can be several factors behind a crash, such as negative economic or business news or panic. Such crashes may also be the result of overblown speculative bubbles and overleveraging of the markets.

Stock market crashes are generally caused by herd mentality, where market participants follow each others’ lead in a panic sell-off, causing prices to fall dramatically and swiftly. Such crowd behavior may be triggered by economic news. Analysis of past crashes show that such meltdowns typically follow an extended period of irrational exuberance, which causes companies’ PE ratios to explode. This problem is further amplified by excessive use of leveraging and margin funding which increases the risk profile of market participants.

There is no definitive or numerical definition of a stock market crash, but a market is said to have crashed when it abruptly suffers a sharp double digit percentage loss in a single day or over the span of a several of days. A stock market crash is different from a bear market which may last for months and in most cases for years. In contrast to bear market, stock market crashes often last for a couple of days only. Stock market crashes may or may not lead to bear market. In the1990s, the bear market in Japan was not preceded by any prominent crash. Similarly, stock market meltdown of 1987 also did not cause a bear market. Though in most of the cases, stock market crashes and bear markets go hand in hand, but their relationship is not linear.

Throughout the history of stock markets, there had been several notable crashes. The most notorious was the Wall Street Crash in 1929.The  US economy was doing extremely well during the decade and the period had seen major technological innovations such as telephone, power grid, aviation and automobiles and radio. The companies like General Motors and Radio Corporation of America witnessed their stock prices touching new highs. Financial markets were also doing well as banking companies were designing and floating new products like mutual funds promising high returns to investors. Investors were increasingly using debt to finance their stock market activities.

Dow Jones Industrial Average was at 63.9 on August 24, 1921. The index has risen six times to 381.2 as on September 3, 1929. However, by this time it had become apparent that the economy is losing its steam. Stock markets reacted to new circumstances and declined several times during the year. Such declines caused investors to panic and became the cause of Black Thursday and Black Tuesday. Black Thursday occurred on October 24 and Black Tuesday on October 29.

Black Tuesday saw DJIA falling by 380 points or 12.8 percent. The index closed at 260. The steep decline caused the exchanges’ infrastructure to crumble. Its telegraphs and telephone lines were not able to manage the selling pressure. Such pressure also took its toll on ticker tape used to show current stock price to investors. Such breakdown of infrastructure further panicked the investors and deepened the crisis. Market crashes are generally exacerbated by margin funding, leverage trading and mass panic sell offs.

Since investors were heavily leveraged, they were obliged to liquidate their positions on account of margin calls. The exchange was flooded with sell orders. New age stocks saw massive decline in their stock prices. During the course of two days, the DJIA feel by 23 percent. By November 11, DJIA had felled by 40 percent from its September levels. The crash was followed by rallies which provide temporary and false relief to investors and eventually led to even bigger losses. DJIA bottomed out in July 1932. By this time, the exchange had already lost 89 percent of its worth. This crash led to the worst economic catastrophe of the century in the form of the Great Depression.

Trading curbs or circuit breakers are employed to avert steep falls in the value of a stock. Such curbs lead to a trading stop in the cash market. In response to cash market, trading is also stopped in derivative market. Circuit breakers are applied in response to significant movements in the market indicators. Depending on the circumstances, trading halts may be applied to any security, class of security or across the exchange. In some cases, major stock markets can stage coordinated simultaneous trading halt in order to avoid major crash. These rules are periodically changed according to the changed circumstances.

Different countries have different approaches towards circuit breakers. United States follows triple tier circuit breakers. For DJIA, the United States have several guidelines. In cases where DJIA breaches its first threshold, a halt is imposed. If the halt occurs before 2 PM then the market is closed down for a period of an hour. If the halt happens between 2PM and 2:30PM, then the market is closed for 30 minutes. If the breach occurs after 2:30 PM then no trading halt takes place.

In case of threshold 2, if the breach occurs before 1 PM, then the market is closed for 2 hours. If the breach happens between 1PM and 2PM, the trading is stopped for one hour. If the breach happens after 2PM, then the market is closed for the rest of the day.

In the case of threshold 3, any breach at any time leads to the closing of the market for the entire day. US regulators determine the threshold levels at the starting of the quarter. Threshold 1 was defined as the drop of 1200 points for the second quarter in 2011. For the same time period, threshold 2 stood at 2400 points and threshold 3 stood at 3600 points. There can also be coordinated trading halts across major exchanges.

France implements daily price restrictions for cash market as well as derivative segment. On the basis of daily transaction volume and the number of securities, different limits are imposed for different securities. For example, more liquid securities have different limit imposed on them in comparison to lesser liquid securities. As an example, if a liquid stock shows movement beyond 10 percent of its previous close, the trading may be stopped for 15 minutes. Once the trading is resumed and the stock price moves beyond 5 percent limit, another halt of 15 minutes is imposed. This may be repeated once more and in the third occurrence, the trading is stopped for the entire day. Any trading halt in the cash market leads to the simultaneous halt in the derivative market as well. France has also enacted similar rules for CAC40 index. In case, more than 35 percent of the index’s capitalization cannot be quoted, the calculation for the index is deferred. In such cases, a trend indicator replaces the index.  If CAC40 index has less than 25 percent of its capitalization quoted, then the calculation is deferred for 30 minutes. In case additional deposits are required, the calculation halt extends to an hour.

Stock markets are expected to follow random walk theory. According to conventional wisdom, stock prices behave according to normal distribution. However, in 1963, Benoit Mandelbrot, a celebrated mathematician suggested that stock markets shows movements much more drastic than that could happen with a normal distribution. He said that the stock price movements are much more closely aligned to chaos theory concept and non linear phenomenon. Mandelbrot suggested that stock prices follow Levy flight instead of random walk theory. Levy flight is a type of random walk with occasional large movements. Gene Stanley and Rosario Mantegna studied over a million records related to S&P 500 market index and calculated the returns for a period of over 5 years. Researchers are now using various computing tools such as simulation to predict crowd behavior. Researchers are also using mathematical and scientific formulas to quantify and predict stock market meltdowns. Conventionally, it is believed that the stock markets and stock prices follow random Gaussian distribution. However, this belief has been widely challenged now.

Well known investor George Soros also referred to market reflexivity and its non linear behavior. He famously stated, ‘Mr. Robert Prechter’s reversal proved to be the crack that started the avalanche’. Researchers working with Massachusetts Institute of Technology have related the stock market crashes to inverse cubic power law. According to Prof. Didler Sornette, stock market meltdown shows the existence of self organized criticality in capital markets. New England Complex Systems Institute researchers have used complexity theory to isolate warning signs for impending crash. According to this research, such crashed are precede by heightened mimicry in the stock market. Researchers also claimed that each stock market meltdown occurring the past quarter of century was preceded by steep increase in the level of market mimicry. Panic is spread easily once investors start following each other closely.

Proceedings of the National Academy of Sciences published a study entitled Switching processes in financial markets showing that general empirical law can be used to quantify stock market performance before crashes. Jim Miekka developed the Hindenburg Omen to forecast market bubbles. Hindenburg Omen is considered to be a controversial market predictor. Recently, a new phenomenon called RR Reversal has been publicized. This phenomenon describes the rapid increase in stock price followed by sudden and inexplicable contraction in the price by 10 to 40 percent within the period of a month. The related phenomenon of JJ Jumpstart may be used to avert RR Reversal.